On March 16, 2007, Menu Foods, an unincorporated open-ended trust established under the laws of the Province of Ontario (TSX:MEW.UN) and a leading North American private-label/contract manufacturer of pet food products sold by supermarket retailers, mass merchandisers, pet specialty retailers and other retail and wholesale outlets set off a chain of events that would go on to expose a fundamental gap in the North American food supply chain. What started a a “precautionary recall” would expand to incorporate 38 brands of cat food and 46 brands of dog food over the next 24 hours. Nearly 1% of all dog food was recalled within a week. Michael Dillion (Dillion Media, LLC), an industry consultant, was quoted in The Economist as estimating pet deaths from the recall would grow into the thousands.

Within 4 days, Menu Foods had lost 45% of its market capitalization (see chart here)

ABC News broke the story on March 23, 2007 that rodenticide (associated chemical name aminopterin), illegal for use in the U.S., was found on imported wheat gluten and used by Menu Foods in approximately 100 brands of dog and cat food. Suddenly, the industry had a sourcing problem, and a big one. The problem was exacerbated on March 29, 2007 when, after a number of complaints related to dry food, melamine, a chemical used in the manufacturing of plastics, was found in the affected wet food, in the kidneys of animals, and in the imported wheat gluten touching off a dry food recall.

After regaining approximately 16% of the value it lost in the stock market between March 16 and March 20, Menu Foods gave back all these gains when it adopted a rights plan to prevent the possibility of an outside party pursuing a hostile take over.

Throughout the balance of March and through April and May, numerous brands were added to the recall list (see full up to date list here). The FDA raided distributors, began sampling all wheat gluten coming from China and even solicited the help of the Chineste government on cracking down on parties responsible for contamination and cross-contamination. U.S. Senator Dick Durbin (D-IL) introduced an amendment that would strengthening human and pet food monitoring, labeling and inspection standards. The Reauthorization Bill, S.1082, which included Mr. Durbin’s amendment passed by a near unanimous vote. In the meantime the recalls go on.

On May 30, 2008, Menu Foods set up a $24 million Settlement Fund to enable parties to recover up to 100% of the economic damages incurred by pet owners, subject to certain limitations. The Settlement Fund, administered by a neutral claims administrator, will be available to persons in the U.S. and Canada who purchased or obtained, or whose pets used or consumed, recalled pet food. The fund amounts to approximately 10% of the company’s revenues for the past 12 months and 120% of the company’s operating income for the past 12 months. Today the company trades at 18.6% of its equity value prior to the recall.

The “demise” of Menu Foods has parallels in other industries. The tort phalanx has biten numerous companies in the pharmacy industry beginning with A.H. Robbins, of Dalkon Shiled fame, Wyeth, of Fen-phen, and more recently Merck & Co., Inc. in civil class action lawsuits associated with Cox-based inhibitor Vioxx. Merck was accused of burying information about risks associated with its blockbuster drug, intimidating scientists and pushing the sales of a drug it knew was dangerous. While the initial break of the Vioxx scandal shaved 40% of Merck’s market capitalization, it had an incredibly strong balance sheet to fund litigation expenses and restructure the company. Two years later the company had recovered all of the lost value.

Another anticipated parallel is Tyson Foods, Inc. Despite being the subject of numerous recalls dating back over 25 years, Tyson’s stock has never lost more than 17% of its value on any one day since January 1, 2000. The dates of the company’s largset losses related to acquisition announcements and indictments related to illegal hiring practices. When the largest beef recall every was announced on February 18, 2008 (some 143 million pounds), Tyson’s stock increased by nearly 10% of its value over a two day period as consumers were expected to increase chicken consumption in light of the news.

If we look for valuation parallels among other publicly traded pet food companies, we don’t find much satisfaction either. Due to their diversified nature, an index of the ten largest public companies with pet food operations tracks, very closely, the S&P 500 during the time of the recall as evidenced by the chart below.

Based on the data above, not much can be derived scientifically. However, my experience has told me the following anecdotal conclusions can be drawn:

1) Since the recall commenced there have been a number of benchmark transactions in the U.S. pet food space, including Mars/Nutro Products (May 2007), Berwind/Eagle Pack Pet Foods (October 2007), Highland Capital/Castor & Pollux (May 2008) and Berwind/Wellness Pet Foods (August 2008). While all the data on these deal (including the date of close for the Castor & Pollux deal) are not in the public domain, it is believed that all of these deals occurred at revenue multiples of between 2.5x – 3.0x. This would be inline with major deals occurring prior to the recall. However, is is our expectation that in order to sustain these multiples going forward sellers will have to have established brand value and be able to demonstrate a requisite amount of control over their input supply chain.

2) It is my view the companies that provide fulfillment pursuant to a co-pack arrangements will experience lower valuations going forward than those that source, manufacturer and pack themselves. That said, these parties are likely to have lower margin profiles and therefore higher multiples may not translate into substantially higher valuations than if they had a co-pack relationship. It is a function of what the multiple is applied to. However, these companies are likely to avoid large set-asides from transaction consideration to fund potential litigation in the future.

3) I expect to see multiples for boutique brands who can make substantive claims around country of origin labeling, health and wellness and nutritional content to experience premium multiples to the historical trends. Wet and dry raw foods will benefit from pet owners seeking out brands that are free from stigma. That said, these products are expensive and therefore are unlikely to get true mass appeal and the sales associated with broad distribution and national branding. As such, their valuation ceilings are potentially capped. However, I expect a number of brands in this category to create substantial shareholder wealth over the next five years.

More to follow as data becomes available.